This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning the link between Konekt Limited (ASX:KKT)’s return fundamentals and stock market performance.
Konekt Limited (ASX:KKT) delivered a less impressive 1.86% ROE over the past year, compared to the 11.41% return generated by its industry. Though KKT’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on KKT’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of KKT’s returns. Let me show you what I mean by this. See our latest analysis for Konekt
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Konekt’s profit relative to its shareholders’ equity. An ROE of 1.86% implies A$0.019 returned on every A$1 invested. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of Konekt’s equity capital deployed. Its cost of equity is 8.55%. This means Konekt’s returns actually do not cover its own cost of equity, with a discrepancy of -6.69%. This isn’t sustainable as it implies, very simply, that the company pays more for its capital than what it generates in return. ROE can be split up into three useful ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:
Dupont Formula
ROE = profit margin × asset turnover × financial leverage
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = annual net profit ÷ shareholders’ equity
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover reveals how much revenue can be generated from Konekt’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check Konekt’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a sensible 69.95%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Konekt’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.